In the Commercial Banking Sector, No Green Shoots Yet

Although analysts have detected “Green Shoots” in the economy signaling the possibility that there may be a recovery occurring sometime soon, it is my belief that we will need to see some signs of life in the banking system before we can get too excited about any sustainable upswing. Right now, I don’t see any “Green Shoots” in the area of commercial banking.

The only indication that something might be starting to happen in the banking sector is the apparent “credit thaw” in the money markets. An article in the Wall Street Journal touts the “voracious demand for short-term debt issued by U. S. and European banks.” We are told by one New York trader that “bank commercial paper ‘flies off the screen.” (See Credit Thaw Is Spurring Appetite for Bank IOUs) The London interbank offer rate has dropped and relative interest rate spreads have fallen, indicating that confidence is returning to this sector of the money market.

Yet commercial banks are not lending. They are not lending to each other and they are not lending to businesses. Commercial banks are still reducing their own debt or just holding onto the cash! The only lending that seems to be happening is on pre-approved home equity loans and on pre-approved credit card balances and other revolving consumer credit. Year-over-year, the change in total commercial bank lending and leases is roughly zero.

In terms of banks lending to other banks, from June last year to June this year, the decline in Fed Funds lending and reverse repurchase agreements with other banks has dropped 15%. These loans have dropped another $60 billion in the four week period ending July 15 from a total of $319 billion!

Credit risk is not the reason that the commercial banks are not lending to each other. In normal times, commercial banks lend to each other through the Federal Funds market or through using repurchase agreements in order to manage their reserve positions at the Federal Reserve. However, these are not normal times.

Commercial banks really don’t need to lend to each other in order to manage their reserve positions at the Federal Reserve because they are over-whelming liquid!

Note that in the two weeks ending July 15, the Federal Reserve reported that excess reserves in the banking system totaled $743.9 billion dollars! This is up from $1.9 billion in July 2008. Commercial banks have no concerns with meeting their reserve requirements because they are holding reserves at Federal Reserve banks that are far in excess of what is required. And, why should there be any trading of Federal Funds when there are such excesses within the system.

The commercial banking system is recording cash assets, as of July 15, 2009, of $958.7 billion which is up from $320.0 billion in the month of June 2008.

Right now, the lending market seems to be compressed on both sides of the market, supply as well as demand. Not only do banks seem to be reluctant to make loans, there seem to be a dearth of borrowers at this time.

The argument on the supply side is that commercial banks still have two major concerns on their minds. The first is the value of assets on their balance sheets. In terms of asset values, there still is the problem of mortgage foreclosures. We are starting a period of re-pricing of Alt-A and Option mortgages at a time when unemployment impacts are growing. Next year there is apparently another round of re-pricings of subprime mortgages. Credit card losses continue to rise. And, there are still big problems expected in commercial real estate loans. This says nothing about the securitized loans that are still on the books of the banks. The second concern of the banks is who to lend to if they were to make loans. Given the uncertainties with respect to the strength of the recovery and the state of the labor market commercial bank lending practice has reverted to the principles of the “good old days” which begin with “don’t lend to anybody that needs to borrow.”

The demand for loans is tepid at best. De-leveraging and saving are the primary focus of a large portion of the business and family population. Small businesses and individuals are scared enough that they are shrinking their needs for outside funding and are looking more and more to greater self-reliance. Experts in the field don’t see this new behavior pattern changing soon. More larger firms that possess some degree of financial strength seem to be moving to take advantage of the economic distress of others and so they are borrowing more, but not from the commercial banks.

The consequence of this? Commercial and industrial loans at commercial banks have declined by more than $120 billion this year. Consumer loans have declined by $30 billion since February 2009. Real estate loans have remained roughly constant this year.

There is still one more factor that is weighing on the minds of commercial bankers. The Federal Reserve has created a situation in which commercial banks have ended up with well over $700 billion in excess reserves. The question on the minds of commercial bankers is when and how will the Federal Reserve remove these excess funds?

It is obvious from his testimony in front of Congress last week that Chairman Bernanke does not have an “exit strategy” for the Federal Reserve to remove these reserves from the banking system.

My question to you is, “Would you lend out these reserves if you had no idea when the central bank was going to take them away from you?” I certainly would not! I think any banker that wanted to put these excess reserves to work under the current leadership of the Federal Reserve would be foolish!

There may be indications that money markets are warming to the commercial banking sector and this is good. However, this is not putting money out into the economy. We need to keep looking at the commercial banking sector to see when lending starts to pick up. Until it does, consumers and businesses will just have to rely on their own resources to finance a recovery. This does not bode well for a rapid turnaround.

Comments

[Tack:]

The issue of lending growth is too often laid at the doorsteps of the banks, when, as you mention, there has been a dearth of demand. The media is all-too-happy to march out some homeowner or small businessman, who says he can't get a loan, and the conclusion that they hope everyone draws is that banks are unreasonably refusing to lend, far and wide. This is not nearly the whole truth.

Regarding the banks' incentives to hold onto reserves, I believe, at least in the short term, this is influenced not so much by any genuine fear that the funds will be called back by the Feds or will be needed to buttress yet-unreserved loan failures, but by what should be a huge concern about the outcome of FASB's recent discussions to force all banks to value all loans (even those held to maturity) at "mark-to-market." Nothing would crimp bank balance sheets faster than putting a huge new segment of asset values into market play with the same ABX manipulators CDS gamblers and naked shortsellers, who nearly brought down the whole system in the first place.

If the banks are permitted to run their commercial operations in a sensible manner and respond to commercial-market forces, I believe they can manage just fine, and the entire economy will gradually benefit. However, if we're going to set up a new round of "game time," then, the recovery and financial system could be in new peril.

Jul 31 04:36 PM

[Mad Hedge F...:]

Don't expect any. Those whose bacon was saved by the Q2 doubling and tripling of bank share stocks, better not count on a repeat in Q3 and Q4. For a start, there isn’t going to be any more government issued adrenaline to ramp prices with TARP’s, TALF’s, ZIRP’s, stress tests, and forced takeovers. The next move in interest rates is going to be a flattening one, cutting into their now hugely profitable margins. Q2 earnings showed that the best performing banks made the largest portion from trading, likely an unrepeatable performance. There is room for only one Goldman Sachs (GS) in the world, maybe two, if you count Morgan Stanley (MS). Wasn’t this the well that poisoned so many of them in the first place? Dare I say that many banks are now overvalued? The quick fingered might even entertain a sector short here in the bank ETF (KBE). For an excellent separation of the wheat from the chaff, take a look at Martin Hutchinson’s work by clicking here .

Jul 31 04:44 PM

[Roger Knights:]

"government issued adrenaline"

aka "Bennies"

Jul 31 06:24 PM

[glendokid:]

I can decide if you believe this stuff or if you are purposely misrepresenting the data.

You said that "cash assets" of banks are up to 749B from 340B a year ago. That's true. But you neglected to state two things:

1. Total loans of these banks exceeds 19 TRILLION dollars. Thus their cash reserves are less than 1% of their loans.

2. The 340 number was a one time exception.

These numbers are all on the same page, you couldn't have missed them. Perhaps you can't add.

Jul 31 07:22 PM

[Mase:]

glendokid:
How can the total loans of these banks exceed 19 Trillion dollars when the total assets of these banks total 12 Trillion dollars. And all these numbers are on the same page!

Aug 01 08:58 AM

[Mase:]

Also, by-the-way glendokid...
where did you get the 749B in the article? I referred to $743.9 billion in the article, but that was for excess reserves in the banking system and not cash assets, which totaled $958.7 billion July 15 2009. And, where did you get the 340 billion in cash assets since the figure in the post is $320 billion. The $320 billion was the average for June 2008. The average for May 2008 was $309.1 billion and the numbers for other months around then were very similar.
Bottom line...I have no idea where you are getting your numbers from. I am getting mine from the Federal Reserve release H.8.

Aug 01 09:46 AM

[M/M:]

There are other reasons that make bank lending to business difficult in this market. There has been a lot of bank consolidations over the last couple of years. Banks that previously determined credit exposures to a business seperately - once the banks consolidate - now want their combined credit exposure reduced to at least the pre-consolidation levels. At the same time, the pre-consolidation levels were high given relative lax lending standards at that time - and now even the pre-consolidation levels are too high given banks's willingness to take risk and the economy's effect on the credit worthiness of the banks borrowers/potential borrows. Thus you will see commerical credit lines reduced substantially as they expire and require renegotiation.

Aug 01 10:50 AM

[M/M:]

There are other factors at work that reduce banks willingness to lend to businesses. One more to mention here. There has been a lot of consolidation in the banking industry since the credit crisis began. Credit exposures that banks were willing to accept for individual businesses were often established before the credit crisis and related recent consolidation of many banks in the industry. Therefore, post - consolidation, banks want to reduce their now combined credit exposures to at least pre-consolidation levels. Thus, they are making less credit available to many businesses. At the same time, they also want to further reduce their credit exposures to account for the economic downturn's effect on borrower credit worthiness. You see this effect as lines of credit become due and are renegotiated to much lower levels of total credit availability (all other things being equal). There are a lot of factors that effect banks willingness to lend - this is just one more.

Aug 01 11:05 AM